Question

Please explain and show graphically the effect of a decrease in the expected inflation rate on the equilibrium exchange rate, everything else held constant.

Answer 1

When there is a decrease in the expected inflation rate, real expected rate of return on domestic asset will decrease. At the same time, the future value of domestic exchange rate increases the returns on domestic assets (through purchasing power parity). The net effect of all these interactions is that it will increase returns on the domestic assets which, in turn, will cause the current value of domestic exchange rate to increase.